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Westport Innovations Inc. (NASDAQ:WPRT)

Q3 2013 Earnings Conference Call

October 30, 2013 17:00 ET

Executives

Darren Seed - Vice President, Investor Relations and Communications

David Demers - Chief Executive Officer

Bill Larkin - Chief Financial Officer

Analysts

Laurence Alexander - Jefferies & Company

Susan Lin - Deutsche Bank

Ann Duignan - JPMorgan

Rob Brown - Lake Street Capital Markets

Jerry Revich - Goldman Sachs

Eric Stine - Craig-Hallum

Colin Rusch - Northland Capital Markets

Alex Potter - Piper Jaffray

Matthew Blair - Macquarie Capital

Pavel Molchanov - Raymond James

John Quealy - Canaccord Genuity

Operator

Thank you for standing by. This is the Chorus Call conference operator. Welcome to the Westport Innovations Inc. 2013 Third Quarter Financial Results Conference Call and Webcast. As a reminder, all participants are in listen-only mode and the conference is being recorded. After the presentation, there will be an opportunity to ask questions. (Operator Instructions)

At this time, I would like to turn the conference over to Darren Seed, Vice President of Investor Relations and Communications. Please go ahead, sir.

Darren Seed

Thank you and good afternoon. Welcome to our third quarter conference call for fiscal 2013. It’s being held to coincide with the disclosure of our financial results earlier this afternoon. For those who haven’t seen the release and financial statements yet, they can be found on Westport’s website at www.westport.com.Speaking on behalf of the company will be Westport's Chief Executive Officer, David Demers and Westport's Chief Financial Officer, Bill Larkin. Attendance at this call is open to the public and to media, but for the sake of brevity, we are restricting questions to analysts.

You are reminded that certain statements made in this conference call, and our responses to various questions may constitute forward-looking statements within the meaning of U.S. and applicable Canadian securities laws, and such forward-looking statements are made based on our current expectations and involve certain risks and uncertainties. Actual results may differ materially from those projected in the forward-looking statements.

Information contained in this conference call is subject to and qualified in its entirety by information contained in the company's public filings and except as required by applicable securities laws, we do not have any intention or obligation to update forward-looking information after this conference call. You are cautioned not to place undue reliance on any forward-looking statements.

Now I will turn the call over to David Demers.

David Demers

Thanks Darren. Good afternoon everyone and thank you for your interest and support for Westport. 2013 is an exciting transition year for us as markets for natural gas vehicles are shifting rapidly into a high growth phase. We’re shifting our business focus and our operating portfolio from our proof of concept phase into our OEM model. We’re also going to see the transition from our investment phase into sales and profits to help you understand our trajectory I will through some of the highlights of our current product scope, our market penetration expectations in key markets, our cost to profitability and then targeted investments from our recent financing transaction. As you can see from the press release Q3 was a strong quarter with growth in both our joint venture businesses and in the Westport product business. We’re up over 50% year-over-year in revenue for the quarter for Westport, CWI was up 70%, Weichai Westport was up 95%.

Now as we rebalance our product portfolio Cummins Westport’s new ISX12G is off to a great start this year with a higher ratings began to ship in August we expect very strong growth in CWI and with this new product over the next few years. As more fleets adopt natural gas this is also going to support rapid investment in reviewing infrastructure.

On the reviewing the topic the launch of our Westport iCE PACK LNG tank system is on to a great start with an order for 900 units over two years from Universal LNG as we announced this morning. I’m sure most of you figured out that the engine in those vehicles will be a Cummins Westport ISX12G so it's an equally positive announcement for us on that front too.

But they are supplying iCE PACK’s to our OEM customers we’re planning the launch of the 13 liter Volvo product with Westport HPDI for next year, our stated long term business model is to work with OEMs and their supply chains to deliver Westport content to the market. This gives both Westport and our partners a relatively capitalized and low cost product going path since we share much of the development and production cost over their current diesel product lines. The proof of his model works is clear with our two engine joint ventures, although the joint venture structure is not an essential thing going forward you can clearly see that Westport and our partners have been able to launch a series of new products with almost no new capital investment and with relatively low development cost. As the markets for natural gas vehicles are in their infancy today we expect that many more products are going to be launched over the next decade, this provide model maximizes returns and minimizes risks to impart [ph] our value chain.

Now as we said we’re currently working with a number of new OEMs to explore how natural gas versions of their current and future product lines could be of high strategic importance to them, we’re moving quickly into specific product development programs with these customers and as we announced last month we expect to be able to disclose 1 to 3 new OEM relationships in the heavy duty space over the next year. Now in rebalancing our product portfolio to support this OEM production model we will be transitioning our unfit [ph] products to a combination of vertically integrated products with our OEM partners and aftermarket (indiscernible) options using proven Westport technology and components.

For example the current generation of HPDI which is on the Westport 15 liter engine, we still assemble that in Vancouver using an uptick [ph] process as we shift to OEM HPDI products we have agreed with Kenworth and Peterbilt that the last day for orders for the 2013 certification of the 15 year end is going to be November 15th, 2013.

West is going to continue to offer an HPDI solution for Australia in consort with Westport’s fueling partners for the foreseeable future. Westport is obviously going to try and deliver the best customer experience and we’re committed to the continuation of class lean [ph] support for all of our customers. So in 2014 we’re going to leverage the service and support activities of our U.S. operations to take advantage of logistics and to better support this U.S. base. We are going to be unveiling what we call HPDI 2.0 the architecture for heavy duty engines over the next few weeks. We have reengineered the entire system to make it manufacturable, scalable, applicable to a broad variety of engines and perhaps most important we expect to see a dramatic decrease in system cost.

As we have seen, there is intensive developing around the world, but natural gas is a desirable fuel for high fuel used applications. Obviously, trucking is the first example of that, but rail, marine and mining we have been talking about for the last year or so. In trucking, we are still at the very beginning stages although it’s quite clear that growth is underway. In 2012, we saw less than 1% market penetration for gas. We think it was about 0.75% to be exact. So that’s of the new Class A trucks shipped in the U.S. and Canada, under 1% were natural gas last year.

We are out looking about 1.5% this year. And of course, Cummins Westport and Westport are about 100% share of the engines in those trucks. Westport and others share the off end of the components, but next year, most people and we concur expect that the truck market is going to go to 4% to 5% natural gas. On a base of 200,000 new trucks in Canada and the U.S., that’s a significant shift in energy use. And over the next five years, industry analysts are calling for 10% to 20% market penetration in North America. And assuming that infrastructure investment keeps up, basic arithmetic tells us that even the low end of those numbers is going to yield great value for our shareholders. We believe the same patterns now playing out in Asia and Europe and we are positioning Westport to take advantage of this opportunity. And then of course, we want to replicate that in other markets like rail and mining.

Now, as you saw at the end of the third quarter, Westport strengthened our balance sheet to support specific investment opportunities and will increase our future product portfolio and to maintain key components and equipment within the natural gas supply chain. To support the introduction of HPDI 2.0 components, we have developed relationships with several global supply partners, all of whom we are going to be able to deliver as the scalable production we will need as this global market develops. We have allocated $40 million to $50 million which we spend over the next two years to invest in dedicated Westport equipment and tooling to be located within our production partners facilities. This allows us to control our IP for some of the critical system elements, ensure that we have full understanding control of critical processes and of course, this investment will help reduce cost in the increased quality.

We have also allocated $20 million to $40 million to support specific product development programs with new truck OEMs. And this will be spent over the next three years. You don’t expect us to increase our burn rate. Simply put, we expect programs that are now in the R&D phase. We are moving to commercialization and as these new programs come in to develop we would be facing all programs out. So we expect that the overall cash burn rate isn’t going to change significantly.

Now, we announced a new program few weeks that are targeting automotive OEM partners. We expect a number of automotive OEMs to be interested in this. We are going to develop a direct injection natural gas system that’s going to align with the industry’s introduction of direct injection gasoline engines. Direct injection of gasoline of course is delivering great improvement in performance and fuel economy. We believe this is going to the future of natural gas as well and direct injection of natural gas will offer equivalent benefits.

Finally, we are seeing a lot of interest in the use of LNG as a fuel for marine vessels. So as part of the offering that we did at the end of September, as you can see we are allocating $20 million to $40 million to support product development in this area with our OEM partners. Now, Bill is going to take you through the numbers and layout our path to profitability, but as you can see from the press release, I think we have laid out our trajectory quite clearly. We have established a meaningful scorecard that is going to let you track this path to profitability. The industry I think is growing beyond many people’s expectations. I firmly believe that we and our shareholders are in the right place to take advantage of this new opportunity.

So thank you again for your support and interest and I will turn the turn call over to Bill.

Bill Larkin

Thanks David and good afternoon everyone. I will begin with a brief overview of our third quarter results. For the quarter ended September 30, 2013, we recorded consolidated revenue this is excluding our joint venture revenue of $46.5 million compared to $30.7 million in the prior year period, a 51% increase. Segment revenue for the quarter was $20.3 million for Applied Technologies, $17.8 million for On-Road Systems, $8.4 million for Corporate and Technology Investments, $77.5 million for CWI and $114.6 million for Weichai Westport, our joint venture. Our consolidated gross margin and gross margin percentage for the third quarter were $16 million and 34.4% compared with 7.8 million and 25.4% respectively in the prior year period. The third quarter’s gross margin was positively impacted by 9.9 million in service and other revenue earned at a 100% gross margin. Research and development expenses were 23.5 million for the third quarter an increase of 7.1 million from 16.4 million same period last year. This increase is primarily due to our investments in new proprietary technologies and long term product development in addition to our development agreements with Volvo, Tata, GM and other OEMs which are recorded in our corporate and technology investment segments. Selling, general and administrative expenses increased by 3.1 million to 19.4 million for the third quarter compared with 16.3 million of prior year period.

For the third quarter of 2013 our net loss is 30.2 million or $0.53 loss per share compared with the net loss of 32.5 million or $0.59 loss per share in the prior year period. Including the third quarter net loss is 1.3 million net foreign exchange loss compared to a net foreign exchange loss of 7.4 million from the prior year period mainly attributed to the movement in the Canadian dollar relative to the U.S. dollar which is unrealized.

Excluding this impact our consolidated net loss and net loss per share for the third quarter were 28.9 million and $0.51 per share respectively. As of September 30, 2013 our cash, cash equivalents in short term investments balance was 89.3 million compared to a 135.3 million at June 30, 2013. On October 1 we closed our offering at 6 million of common shares in United States and Canada and our cash balance after closing was 237.5 million.

During the third quarter we used 46 million in cash which included 12.4 million in debt repayments excluding these payments cash used in third quarter was 33.6 million. Also for third quarter our consolidated adjusted EBITDA loss was 19.5 million. I will come back in a minute to discuss the segments financial performance but let’s pause and put this quarter’s loss in context of our business in the path to profitability.

We have been describing for Westport financial plan in our past from our current heavy investment phase to overall cash flow and profitability. We believe our business model can and will deliver great value to our shareholders as this market shifts plays out.

In the near term we’re laying out specific metrics and milestones so you can see and measure our progress. The path will be straight line of course but our progress should be very visible. So to be clear we’re talking about two milestones here. First, operating unit adjusted EBITDA which is defined as operating income less non-cash items and this will shift from approximately 9 million negative per quarter this year to breakeven in positive by the end of 2014. We also are investing in long term product development at the corporate level and will have corporate public company expenses to cover as well. We report these in the corporate and technology investment segment and you can watch our progress here too.

We have averaged about 16 million per quarter adjusted EBITDA loss this year in the segment. We are committing to manage the business so that by the end of 2015 our corporate investment portfolio and our other expenses include long term capital investments will be covered by three things, internal operating income, income from joint ventures and expense recovery from our development partners. Obviously we expect that our current investment portfolio will contribute to our income strength and these investments were lost into production we have options on the pace of new investments to ensure we can manage this goal therefore we expect by the end of 2015 Westport will be positive adjusted EBITDA at the corporate level and we believe the path forward to strong financial returns is clear.

Now I will walkthrough each of our business segments starting with Applied Technologies business unit. Applied Technologies revenue for the third quarter was 20.3 million compared to 20.8 million in the prior year period. A 500,000 decrease is primarily due to lower sales in China, and South America partially offset by stronger sales in Russia and Poland. Gross margin percentage were 6.5 million and 32% during the quarter compared to 5.2 million and 25% of prior period respectively. Including the current quarter’s revenue is 969,000 of service revenue which was recorded a 100% gross margin since the related cost were recorded in R&D therefore product gross margins for the current quarter was 28.5%.

Operating expenses increased 1.5 million and 4.9 million for the third quarter compared to the prior year period which is primarily attributed to a higher research and development cost for new products. The On-Road systems business unit revenues were 17.8 million compared to 8.5 million in the prior year period, an increase of 9.3 million driven by revenue generated from BAF and an increase in sales of HPDI systems. Gross margin and gross margin percent for the quarter were $1.1 million or 6.2%. Operating expenses for the quarter were $9 million and this is flat compared to the prior year period.

The Corporate and Technology Investments business unit earned $8.4 million service revenue related to our development agreements during the quarter. Operating expenses increased by 49% primarily due to higher investments in research and development activities on new and existing development program and additional resources to support market development initiatives.

During the quarter, CWI earned $77.5 million in revenues and shipped over 2,400 units compared to $45.5 million and 1,588 engines in the prior year period. The increase in revenues was led by deliveries of the ISX 12G engine and further increased by shipments to Asia. We continue to see high interest and demand for the ISX 12G engine. Operating income was $7.9 million or 10.2% of revenues compared to $7 million or 15.4% of revenues in the prior year period. This decrease in the operating income percent was primarily due to operating expenses increasing 53% to $9.8 million which is driven by research and development expenses related to the ISX 12G, the development of the ISB 6.7G and reliability improvements and $6.6 million warranty adjustments for the ISL G recorded during the quarter.

Our portion of the CWI’s net income for the quarter was $2.5 million. We expect our portion of income to increase as unit volumes increase. And we realize improvements in our warranty experience. Also, we expect CWI’s revenues to exceed the 2013 baseline revenue target as defined in the amended joint venture agreement, where we will recognize 75% of the profits earned in excess of the baseline revenues, which will show up in the Q4 when we report our share of CWI’s income. We expect Westport to rely significant growth again on third quarter of 2013. Third quarter sales volume grew to over 9,000 engines, an increase of 88% from the prior year period. We expect Westport continues to penetrate new markets and build market share aggressively in China. Therefore, margins still remain in the single-digits.

With that, I will now pass the call back to the operator to open the call for questions. Operator?

Question-and-Answer Session

Operator

Thank you. We will now begin the question-and-answer session. (Operator Instructions) The first question is from Laurence Alexander of Jefferies & Company. Please go ahead.

Laurence Alexander - Jefferies & Company

Good afternoon. I guess two quick questions. One is the wind down of the HPDI 1.0, what will be the run rate savings from doing that?

David Demers

Good question, Laurence. I am not sure, we can say. Obviously, we are redeploying a lot of resources and that was what we are trying to say we are going to be leveraging a bunch of our U.S. production sites. I think it’s more accurate to say we are reconfiguring our U.S. sites to support the OEM programs and get ready for – get ready for OEM launch, but it’s going to be across the product portfolios. We want to be kind of unsiloing. As you know in the past, we have done a fair amount of specific work for the products developed with Ford, for example, the products we have done with PACCAR, work we are doing with Volvo. So what we are trying to do now is consolidate operations and Nancy Gougarty has joined us. She is working to get efficiencies and come across the company operating synergies so that we can start to make money as opposed to losing money in that division. So I think it’s fair to say you are going to see a lot of product change, a lot of movement of our operations and then overall that’s going to support our path to profitability, but getting into specific product by product what are we doing I don’t think that’s really going to be very helpful.

Bill Larkin

Let me still add a comment, Laurence, we do expect to recognize some benefit.

David Demers

It’s all part of – it’s all part of path to profitability.

Bill Larkin

Yes.

Laurence Alexander - Jefferies & Company

Okay, but I guess it’s been such a flagship product for you, but also such a low volume products, is it fair to say that probably the savings would be at least equivalent to one new incremental program in terms of funding or is it less significant than that?

David Demers

It’s I mean just look at the losses we racked up. I am looking at Bill here, but it’s no secret that we have never hit the breakeven point when we talk about for years on that. Its product is first generation, the price is high. And certainly with the introduction of the 12 liter product that is built on the line and with iCE PACKs that are being taken advantage of 2.0. The product is high priced, it applies well to high fuel used applications like we’re seeing in Australia for a price point makes some sense but we just don’t see the breakeven point for that specific product. Is there going to be a next generation product coming? That’s you know obviously that’s what we would be pushing for but in it's current state you know I think the last time I looked we were probably putting together operating loss of certainly 10s of 1000s per truck for the truck that we ship just to build it and support and the fixed cost. We’re not going to be able to necessarily erase all of that fixed cost and we’re probably going to redeploy a lot of the resources but it's going to be allocated to places where we’re making money. So I think it's going to have a very significant benefit on us.

Laurence Alexander - Jefferies & Company

And then just very quickly in terms of lumpiness you know as you think about your cash burn for the next two to three quarters, are there any significant factors that will affect the cash burn you know that are just following you know not just unit volume projections?

Bill Larkin

Yeah I’m not aware of any at this time Laurence as we look forward.

David Demers

And it's going to that goal by the end of 2014 for the operating business unit so for you know for the quarter ended December 31, the BUs should be adjusted EBITDA positive.

Operator

The next question is from Vishal Shah of Deutsche Bank. Please go ahead.

Susan Lin - Deutsche Bank

Hi this is Susan Lin for Vishal Shah thanks for taking the question. I wanted to get some color on the 15 liter I know you’ve mentioned some nice orders this quarter some of your peers have been talking about a slowdown due to the rest of the year and wanted to see you know how that juggles with what you’re seeing and then two how that relates to I guess you’re stopping to take orders in a couple of weeks and then I’ve a follow-up question.

David Demers

Well obviously Susan I mean this is a business decision, I think we’ve got the next generation coming off the HPDI and that’s vertically an aggravated product obviously Volvo is launching with it at the end of next year. I think this just came down moving to the vertically integrated solution. Right now the first generation product was, I mean it was a Westport branded engine with HPDI and we’re just moving to the vertical integrated business model and you know and the engine will be a 12 liter Cummins Westport engine which will be a great engine and by the end of next year should start to see some Volvo 13 liter product down the road with HPDI and I think again it was just a business decision we had some great orders come in, we had a good Q3 in terms of sales for the first generation product and ironically one of the best things I think we could have maybe done was suggest that we are moving next generation product because it's sped up a lot of business which has been very positive for Westport for this quarter and don’t mind suggesting even the next quarter.

Susan Lin - Deutsche Bank

And then wondering if you guys can give us an update on how your sales agreement with Weichai is going in terms of your June exclusivity agreement pending?

David Demers

Bill is flying to China, no I think it's going very well. Let’s just start with that, I think the market in China took a bump over this summer a lot of people recognized that the Chinese government changed the pricing for natural gas for trucks because the volumes were rising so quickly and we’re not too sure what exactly is going on with the pricing of diesel fuel and gas in China because it is controlled by the government but as people digested that you know volumes are back on the rise again and so the demand for HPDI is strong. I think the question between us and what we try to is just exactly where it is and how we’re going to roll that out and what the price point would be and what the volume is going to be. It's I think it's a really exciting opportunity for both of our companies.

Susan Lin - Deutsche Bank

And how long does it take typically I guess what’s the lead time that you would need, is it six to nine months? Is it I mean should we expect that sooner than later given the time needed?

David Demers

I mean obviously there is a process going on here Susie we’re not trying to be cagey, there is a large investment that we’re making in key component capacity for HPDI 2.0 it's obviously that’s going to support Weichai’s rollout. Between the time that that hardware gets on to the plant for. We are using current equipment, which we are going to be effectively renting at a higher price. So lot of this is a trade-off between price and scalability in volume. We expect that we will see low volumes relatively low volumes let’s say. I think we are going to see some pretty healthy demand in China until we get these investments in place. So we can deliver the price point that we need in China, but this is going to be a global supply chain and we wanted to be scaling up to meet the demand that I talked about earlier. So that should give you a sense of where we think this is going over the next couple of years. Can I give it to you quarter-by-quarter or not? It’s not meaningful, but we can deliver some trucks very quickly and we will be in production soon.

Susan Lin - Deutsche Bank

Okay, thanks Dave. Thanks guys.

Operator

The next question is from Ann Duignan of JPMorgan. Please go ahead.

Ann Duignan - JPMorgan

Hi, good evening.

Bill Larkin

Hi Ann.

David Demers

Hi Ann.

Ann Duignan - JPMorgan

Alright. Could you give us a little bit more color on the Universal LNG announcement that you had this morning? I mean, I am just trying to visualize how is that going to work? I mean, we looked at their website, it’s just like they are based in China. Are these products that are going to get assembled here in the U.S. and shipped to China? Can you just give us a little bit more detail about what exactly?

David Demers

No, Universal is another entrant into the U.S. market. There has been a number of specialists in China building LNG and they are moving operations into the U.S. So this is a U.S. operation. It’s for a U.S. customer. This will be a U.S. fleet. And of course, our traditional iCE PACK production will be here in the U.S. So no, it’s just Universal like others are seeing the opportunity to invest in LNG infrastructure and they are all signing up fleets. Their focus is more the private networks and building the public station network as far as I know. So they are building in-yard refueling for large fleets and obviously doing a good job of it, because they are capturing customers.

Darren Seed

We have – and it’s Darren, we have been precluded for mentioning the customer name and the OEM chassis. We do know the answer. It’s just the customers have currently requested anonymity and – but their household names in North American soil.

David Demers

I mean, I will elaborate a bit as we have (indiscernible) question today. So Ann, since you kicked off, I can last on about this a bit. We have been seeing for a while that the LNG delivery system is really biased towards cold LNG and so are the fleets. The fleets are going to want to optimize range and performance and so they the colder the better for that. And so part of what is happening here is that the fuel providers are biasing the OEMs toward a cold LNG solution by offering the hardware, so now Universal is not buying iCE PACKs, they are on behalf of their customer. We are saying we are going to deliver cold LNG solution and to guarantee that these trucks meet our spec we are going to pay for the fuel tanks. And so this is part of the model that we have been talking, but I think the industry is recognizing the benefit of this and the importance of this technology. And I think you will see more and more of these deals that are being sponsored by the fuel providers. The OEM, it doesn’t really care what the hardware spec is for interaction with the station, particularly when the station builder is specifying it. Does that make sense?

Ann Duignan - JPMorgan

Yes that’s helpful. I couldn’t logistically figure out my mind why we would be shipping tanks to China so.

David Demers

To the U.S.

Ann Duignan - JPMorgan

Okay. And is there any risk on the tank side that we get ourselves into the same issue that we had with the HPDI and that you are shipping engines from the OEM to a third-party location and you are putting a HPDI and then you are shipping them back to the OEM and a lot of the inefficiency in the logistics and the cost, so it’s about maybe added to the lack of breakeven in that business? Is there any risk at the same on the tank side, you are just buying the tank, you are putting in all these pumps and hydraulic systems and then shipping it back somewhere? Should we be concerned about profitability of that business?

David Demers

Yes. No, obviously this is – as we said iCE PACK is an HPDI 2.0 architecture. The idea is to share the volume with our HPDI OEM customers and downsize it for SI with a different drive system, but it’s exactly the same component. So we are taking advantage of the supply chain and the engineering cost reductions that we have made on HPDI 2.0 to launch this product. So no we’re going to see very healthy we think quality improvements, price improvements and we can pass that benefit onto the customer.

Bill Larkin

And it's integrated and I think a different model for iCE PACK and say some of the standard solutions where it's I think affected almost all external integration. The iCE PACK really is dedicated for online and factory production at the truck plant. So whether it's Kenworth, Peterbilt, Freightliner any other Autocar, whoever the OEM is the iCE PACK would get delivered to the model would be is that the iCE PACK system gets delivered to the OEM plant and then integrated on the line.

Ann Duignan - JPMorgan

And so you value add in the process is exactly well is it the pump design or hydraulics or the packaging?

David Demers

I’m sorry I don’t think I heard your question, could you repeat it?

Ann Duignan - JPMorgan

I’m trying to figure out what Westport’s value add is than in the iCE PACK system?

David Demers

Well I mean it is our proprietary tank and pump combination there isn't another automotive grade pump that works frankly and it's pretty simple and the tanks are manufactured to our specs as a result. So it's a proprietary Westport product top to bottom. Of course the other advantage is that we understand the fuel flow rates of the engine needs and we can match the controls on the fuel system to controls in the engine so if the engine gets the fuel flow that it needs and so the performance of the entire system is you know is guaranteed by the fact that we know what the system needs. Linkages to the fuel station and cold LNG is I think another one of the system benefits we have talked about. So I think it's really important at the end customer level to you know understand that the ship to natural gas is fully engineered from end to end and the truck is going to perform and take advantage and then what people care about is performance and fuel economy and that’s what iCE PACK is doing with trucks with a 12 liter engine. So yeah it's proprietary end to end.

Operator

The next question is from Rob Brown of Lake Street Capital Markets. Please go ahead.

Rob Brown - Lake Street Capital Markets

You talked about your HPDI 2.0 rollout and steps coming, could you give us a sense of what steps are coming and when sort of the CapEx flow-

Bill Larkin

No. I think David mentioned in his script well that is basically being designed for manufacturing high scale liability lower cost, we’re just making changes in our own supply chain and design and engineering of HDPI and I guess the finishing nodes [ph] you may have to just wait a few weeks to see the development.

Rob Brown - Lake Street Capital Markets

Okay but these should be things like manufacturing partners being announced that kind of thing?

Bill Larkin

Yeah that’s fair, yep.

Rob Brown - Lake Street Capital Markets

And then maybe this is another question you won't answer but could you give us a sense of kind of what the attach rate of the iCE PACK will be to the 12 liter sales what’s kind of the unit volume ranges we can kind of think about for this product?

Bill Larkin

It's a function of LNG in tracking applications doing maybe more than 250 miles a day; you know I think there is a lot of discussion I guess candidly about how much LNG and trucking is going to be shipped next year versus CNG. As you know we obviously still ship the Cummins Westport 12 liter engine, it's going to do great. I think in terms of the attachment rate I will let you the analyst community, investment community decide what you think you want to forecast the mix of LNG out of this 4% to 5% market penetration Dave talked about and then in terms of our attachment rate of the LNG are we going to get 100% of the LNG system versus perhaps an industry standard offer, you’re probably asking a little subjective question to us Rob I think, we think we have got the best solution possible for LNG and spark ignition engine. So I will just wave the flag of subjectivity and say I think it will be a good attachment rate based on how many truck applications we will ship with LNG and longer haul.

David Demers

And Rob you’ve seen our chart; we are trying to be completely neutral on this. Some of this is physics but there is also a factor of local availability of LNG and foot preferences and some of it is whether the fleet is also running a big CNG operation, which cases are probably going to be biased with CNG, but as Darren said, we really see the dividing line of kind of 200 miles a day. CNG above that points for us to really get some challenges and we would expect the great majority of fleets that have higher miles in that going to LNG. The overall mix on the 12-liter is anybody’s guess, but we have here at the industry, these days is talking 50:50 whether it’s 60:40 or 40:60, I don’t really care it’s our engine. I think LNG is going to be Universal in high fuel use applications like marine and I don’t know actually, you maybe not a marine, but for the most part you are not going to see LNG mining trucks or CNG mining trucks rather or CNG for rail doesn’t make a lot of sense. So you kind of have to draw the line based on we think fleet preferences. I think how we see adoption of natural gas in the short-term, we are going to see lots of CNG, because if those return to base fleets and urban fleets that get immediate advantage and the infrastructure barriers are lower, but over the next two or three years, I think you are going to see a lot of LNGs just…

Darren Seed

Much of your mix that way, Rob.

Rob Brown - Lake Street Capital Markets

Okay, thank you. I will turn it over.

Operator

The next question is from Jerry Revich of Goldman Sachs. Please go ahead.

Jerry Revich - Goldman Sachs

Good afternoon and good evening.

Darren Seed

Hi, Jerry.

Jerry Revich - Goldman Sachs

Can you talk about the Volvo HPDI timing, you mentioned by year end 2014, I am wondering if you just clarify that full scale production rates and just give us some more context about how you expect the ramp to go?

Darren Seed

Yes. Hi, Jerry, it’s Darren. The comment we have been given by Volvo, they actually gave at the Mid-America Truck Show was late 2014. When you get this close to product launch to be really candid, it’s actually Volvo’s call. We don’t have the exact date from Volvo.

Jerry Revich - Goldman Sachs

Okay, thanks Darren. And in terms of the BAF acquisition, how much did it contribute to sales in the quarter? Can you share with us the HPDI sales contribution in the quarter as well?

Bill Larkin

Yes, I think we talked about this last quarter, where we are not going to breakdown the individual businesses. So we are not going to be able to provide any color on that.

Darren Seed

In terms of units, I don’t know, is there any – is there another way we can try and answer the question, Jerry?

Jerry Revich - Goldman Sachs

Yes, Darren. Just can you help us with the organic growth in Applied Technologies in the quarter or excuse me in On-Road Systems in the quarter backing out the BAF contribution?

Bill Larkin

Yes. I think yes, we have got increase in the HPDI sales and increase in the contribution from BAF. This is the first quarter that you actually started recognizing revenues related to BAF.

Jerry Revich - Goldman Sachs

Right yes. So I didn’t ask my question well. So if you were to back out BAF what would the sales growth be in the quarter on a year-over-year basis?

Darren Seed

I think it’s the same question. Sorry, Jerry, we will try – we are trying, we just can’t break it out.

Jerry Revich - Goldman Sachs

Okay. And as we think about your business stepping into next year, what are the major light duty launches you folks have coming up or major product refreshes. Dave, can you just give us a quick update on maybe the two or three biggest programs?

Darren Seed

I think there is probably two to start out with and looking to Dave and Bill for any others. You have got one is the Ford F-150, which we still expect to launch in Q1 of 2014. And also the Volvo V60 program has started selling. And we are looking at an export market for that product over the next 12 months. I don’t know is there any other for light duty, I think that’s what we have on the table right now, Jerry.

Jerry Revich - Goldman Sachs

Okay, thank you very much.

Operator

The next question is from Eric Stine of Craig-Hallum. Please go ahead.

Eric Stine - Craig-Hallum

Everyone, thanks for taking the questions. Just I know you are hesitant on the units, I am just curious can you just talk about maybe the magnitude within CWI as the 12-liter I mean last quarter, you had a great CWI number and the 12-liter was very small. I mean, should we think about this quarter in a similar way or just kind of help frame us and again I am trying not to ask about volumes, but just kind of help frame our thoughts on that?

David Demers

Well, you really want the unit numbers, don’t you? I am looking at Bill how can we give you a hint here, I mean volumes are going up. We can certainly say that and is it fair to say we doubled quarter-to-quarter (indiscernible) doubled, honestly we’re really getting I think distracted by this, I think the real point is what we I guess I said it I will say it again you know that this breakeven sorry breaking into a market where we’re going to get 4% or 5% market penetration per gas is really what has got people excited so the story is not last quarter or this quarter is I think everyone now believes we’re going to see a market for natural gas in 2014 of 8000 – 10,000 trucks which is a lot of natural gas trucks and that has everybody scrambling to get their product lines together. So the numbers we look for I think is are we going to be able to get to that 4% or 5% market penetration in 2014 and then after that is it going to keep doubling in the U.S. If you do the math and look at China we think we’re getting pretty close to 5% in China which is a pretty astonishing number in a short time too. Europe we’re behind but it's not unnoticed the natural gas is moving quickly in North America and that’s why we’re seeing so much interest in Europe as well.

So I think that the critical number is not the (indiscernible) I can tell you that ’12 is doing really well and volumes are growing and we’re in full production as of August with the high ratings and that product seems to be what people want. So we’re pretty confident we’re going to have a strong year ahead with that product and then our whole flood of new product is going to hit the market after that, that’s I think is pretty safe to predict. There are couple of data points to play with one.

Eric Stine - Craig-Hallum

So maybe just turning to Applied Technologies something from the release, just wondering if you can give more clarity, you talked about new high pressure natural gas system I guess it's a valve, a tank valve and a filling valve you know how we should think about that opportunity maybe in terms of ASP and then as much as you can share about these two European OEMs you know once in Europe maybe which markets in Europe those sorts of things.

David Demers

Sorry the two European OEMs and wanting Darren for that reference, two European OEMs?

Darren Seed

So these are the new products that they have been investing in in Applied Technologies, is it just they are rolling out these new products that are OEM quality you know all the OEM requirement is (indiscernible).

David Demers

I think we do expect Applied Technologies to have some pretty growth with it's new products launching in, at the end we will frankly sound I guessed at the end of the year and some products launching next year, we haven't disclosed yet. I think Applied Technologies has got some good growth in front of it.

Eric Stine - Craig-Hallum

Okay so this I mean part of your plan on feeding existing you know players in the supply chain this would be I guess the first of many is that how we should think about it?

David Demers

Yeah I wouldn’t necessarily say we’re feeding people, I think the market the OEM market is just emerging and what we want to be able to do is demonstrate a continuous stream of new products you know they are higher performance lower cost, better quality. You know it's pretty standard automotive business and the Applied Technologies Group are focused on that OEM business. We have got I think a very good presence with the automotive players that are doing natural gas and we want to expand our content, and we want to obviously expand the model coverage and expand the number of OEMs that we supply which would lead them directly into complete system design with our On-Road Systems Group but the Applied Technologies Group will sell stuff to anybody.

Eric Stine - Craig-Hallum

Okay and last question from me I know iCE PACK clearly focused on North America but just any thoughts on timing you know potentially spark ignited opportunity in China?

David Demers

Well there is a lot of sparking item getting sold in China. I wouldn’t say iCE PACK is North America.

Bill Larkin

This time we’re looking at possible solutions Eric for product launches and we’re looking at partners right now and we would announce anything of materiality when they are ready to go.

Operator

The next question is from Colin Rusch of Northland Capital Markets. Please go ahead.

Colin Rusch - Northland Capital Markets

Can you guys talk a little bit about the strategy for distribution of iCE PACK and why you are not selling direct OEMs at this point?

David Demers

We are selling direct OEMs.

Darren Seed

We are selling direct OEMs.

Colin Rusch - Northland Capital Markets

Okay. And then ULNG order is just aid on distribution at this point or?

Darren Seed

It’s unique; it’s a little unique at this moment for that particular order, Colin.

David Demers

But Colin as I have said to Ann earlier, what you need to think about here is that the fuel provider working with the fleet is expecting cold LNG in iCE PACKs, but the iCE PACKs are getting put on the truck chassis by the truck manufacturer. It’s a trucking product. So we are not taking iCE PACKs and shipping them to Universal LNG. This is not what’s going on here. It’s just that the fueling partner is specing it on behalf of the fleet. So what we are not telling you is the OEM and we are not telling you the fleet, but it will all become clear once you see this rollout. We do see that continuing. I think that more and more of the LNG providers are going to be very engaged in specing cold LNG and iCE PACK and being able to offer pricing and performance that takes advantage of that technology. And so you are going to see that model going forward, but the hardware itself is it’s an OEM product as Darren said and it’s designed to be installed at the truck factory.

Colin Rusch - Northland Capital Markets

Okay, perfect. And then with the 15-liter, can you just give us an update on where you are at in terms of discussions on new partner for funding the next generation of 15-liter product?

David Demers

I mean as HPDI product we are talking about, I think I have got to choose my words carefully here. What we are seeing broadly across the trucking industry is a push towards higher fuel economy and higher fuel economy with lighter weight comes with lighter weight. It comes with smaller engine displacements, which means higher power density for smaller engines. So I mean, if you look at the ratings, you are going to see higher power and torque ratings out of smaller and smaller displacements, which in certainly in Europe, we are seeing a real migration in the trucking industry to much smaller engines that have the same performance output. So what we are after is not another 15-liter platform, what we are after is a broad range of engines that are suitable for trucking. And more than that, I think we are going to have to stop. Let’s just say that as you see the trucking portfolio around the world evolve, we want to see HPDI offerings in as many of them as we can do.

Darren Seed

I think, Colin, there is bit of a misunderstanding by some of the media that people link the 15-liter as some inextricable link with HPDI, but HPDI is a technology platform. It’s what Caterpillar is working with, what Volvo is working with. Obviously, we have disclosed publicly there are two OEMs we have been in development with so far on initial phase with just that HPDI as a technology platform. So will there be future OEMs with HPDI? Absolutely, I think we are counting on it. Will one of those products, will HPDI be on a 15-liter engine, I think that will be a question for Cummins or for DAF or PACCAR or whoever is the current supply and value chain today.

David Demers

The fleet aspect…

Colin Rusch - Northland Capital Markets

I think that where you are heading is more something I would look more like a chassis then it would look like a product that you just took…

Darren Seed

I mean I will go on a bit on that one, because it’s come up a bit. JVs were a great way to get started and minimize risk for those first partners (indiscernible) because you can kind of – we are isolating the business, we are putting it off in the joint venture. But I think more and more we are going to see business model like we have done with Caterpillar and Volvo where it’s product by product and there is a specific product. There is a product development agreement. We agree on cost and performance milestones for a particular product. And we expect there will be multiple product development agreements with each of these OEM partners as we go forward. So the JV structure isn’t necessarily what we are going to replicate. I think you are going to see more of these contractual product by product deals, which have the same result. It looks in the end. It looks like the same financial deal. It just gives us lot more flexibility with our partners on future rather than going into our corporate structure at the JV. Not really, no JVs just think our expectation talking to our partners is they want lot more flexibility.

Colin Rusch - Northland Capital Markets

Perfect, thanks a lot guys.

Darren Seed

Thanks Colin.

Operator

The next question is from Alex Potter of Piper Jaffray. Please go ahead.

Alex Potter - Piper Jaffray

Just following up on the last question then with the Weichai joint venture, would you say that that’s something that you guys might try to move away from potentially restructure that in the same that you’ve done with Volvo or do you think that JV has staying power?

David Demers

What we said about Weichai is two factors there, in the joint venture was the way we got the Chinese market for natural gas in particular, natural gas trucks and LNG got going and the joint venture was a great way to get some visibility and start on that and obviously it's done really well and it's got a 30 year term, there is a corporate structure that we’re shareholder in but the primary path to market for Westport and Westport shareholders is the value creation. We think it's really going to come as we start to deliver HPDI technology to the joint venture or deliver components to the joint venture or develop a Chinese iCE PACK or something that it could take advantage of this new market for natural gas products. The joint venture obviously has a value and obviously those shares have a value but our business model is to deliver this you know technology driven capital like business model to OEMs and that means Weichai Westport is becoming a Westport customer that’s really what we’re pushing toward.

Alex Potter - Piper Jaffray

Then I was wondering also just I guess one quick question again on this ULNG thing for the 900 units of the iCE PACK I was wondering if there is, do you have any sort of take or pay agreement type of thing there whereby they would get penalized for not ordering?

David Demers

Yes it's a take or pay actually Alex sorry we didn’t put all that detail in the press release but it is a take or pay with minimum commitments every year till we get the 900 units. They can obviously speed up the pace of integration but it was also just a function of making sure they had enough time to get the trucks integrated into the customer fleet and the infrastructure that was there, it was just more of a logistics timing than anything.

Operator

The next question is from Matthew Blair of Macquarie Capital. Please go ahead.

Matthew Blair - Macquarie Capital

When the 350 horsepower version of the 11.9 launched it seemed like a higher percentage for CNG, now that you’ve the 400 horsepower version out there what’s the breakout between CNG and LNG?

David Demers

Sure I think it's just all applications right now. I think we touched upon it you know right now majority of the engines they have CNG today until we get our iCE PACK out there and start getting them integrated on trucks. So if you look at most of the TWI (indiscernible) that are being deliberate whether it's 350 or 400 horsepower there is going to be CNG today.

Bill Larkin

It's the function of the shipments this year Matthew it's for calendar 2013 it's probably fair to say the first application is going out were more CNG based and to David’s point earlier it's the short haul return to base you know refuse fleets, short haul trucking where again every night they can come home and get the efficiencies of having an overnight refueling or depot based refueling solution. As you get into 2014 I think you start seeing the longer haul application showing up more than 250 miles a day and that’s obviously what’s got us very excited about the iCE PACK sales for next year but this year could it be a high mix of CNG? It could be for sure but again I don’t think it's an appropriate survey sample being just calendar ’13 because most of these products are just coming off the line.

Matthew Blair - Macquarie Capital

Any thoughts on R&D for 2014 I guess given the recent equity raise, should we assume it's probably going up next year?

David Demers

Yeah as figured today we think you know our investment, research and development is going to be flat year-over-year. You know we have talked about quite openly as we’re going to be having products or we will be coming out of that product development cycle and put it into the business units and be commercialized and we would expect to bring more new development programs into the investment pool next year. So we expect when we look sitting here today for next year we expect it to be flat.

Bill Larkin

I think the other component Matthew is you’ve got our we have been using that term sort of gross R&D, so the R&D number that we report don’t forget there is obviously a good portion of service revenue. It’s some number I think it’s been in the $10 million to $15 million range or so for this year on a run-rate. I think next year we would expect to have some service revenue. So there would be something else to consider too as even if the reported R&D numbers is flattish, hopefully a portion of that is offset by the service revenue.

Matthew Blair - Macquarie Capital

Okay, but you probably have lower service revenue next year with the rollouts of the Volvo HPDI engine?

Darren Seed

I think that would be dependent right now, Matthew as you are right that as Volvo drops into product sales that will come out of R&D, but we are let’s just say confident in that we have two OEMs we have been working with for the better part of the year on HPDI. If we are successful and we can turn them into development agreements, we may see some R&D out of that. And I think to your other comments on joint venture structures where those are less likely, not only do you expect them to see more product development like agreements, but invariably the customers are less willing to give up a big share of the net income and you are seeing more of a service revenue model where the OEM partners are willing to subsidize or fund some of that R&D development so that they can control greater part of the value chain.

Matthew Blair - Macquarie Capital

Very helpful. Thank you.

Operator

The next question is from Pavel Molchanov of Raymond James. Please go ahead.

Pavel Molchanov - Raymond James

Guys thanks for squeezing me in. You mentioned in the press release that gross margin on the new 12-liter was depressed due to I guess lower launch pricing, how long do you think that will last?

Bill Larkin

Well, it’s all – just to be clear it’s all driven by the warranty accrual that we have on the 12-liter. Like with any new product launch, it’s heavily burdened with warranty costs, so therefore drives down the overall margins. And typically, it will take several quarters as we start getting some performance history on that engine so where we can start at really predicting what that warranty is going to be look like on that product out in the foreseeable future. So it’s going to take several quarters for that warranty experience to come in and we would expect that overall warranty accrual to start decreasing over time and margins to improve.

Pavel Molchanov - Raymond James

Okay. Just to clarify pricing at launch is the same as you plan to keep it?

Bill Larkin

Yes.

Pavel Molchanov - Raymond James

That was not the culprit, okay.

Bill Larkin

I think, it’s just changing what that warranty accrual is that’s going to drive margins.

Pavel Molchanov - Raymond James

Okay, understood. I appreciate it guys.

David Demers

Thanks Pavel.

Operator

The next question is from John Quealy of Canaccord Genuity. Please go ahead.

John Quealy - Canaccord Genuity

Hey good afternoon guys. So one question real quick and I am sorry if you touched on this earlier, in terms of iCE PACK, the warranty charges or ramp, how should we expect that to play, is it going to be similar to the engine launches or less of an impact?

Darren Seed

No, it’s an existing product that’s within our technology portfolio. We have pretty good history on. And so I wouldn’t expect significant warranty accrual on that system once we start launching and delivery. So I think as David mentioned earlier, we think we are going to make some good money on to sell those products.

John Quealy - Canaccord Genuity

Okay. And then lastly another one, I apologize if you touched on it, but in terms of the traditional China market for medium and heavy duty diesel trucks, it sounds like that traditional markets slowing down and fairly operating with fairly good overcapacity. Have you seen any increased competition on the LNG, CNG side at all? Thanks.

David Demers

I think well, I just said the – what’s going on in the China market is not always obvious. From our data, things are roaring again in the truck business. So there might have been some lumpiness, but it’s still a very strong market and continuing to grow pretty well and natural gas continues to grow. Now there are a number of players in the engine business, but Weichai is the dominant player in the truck business. And obviously we dominate in the natural gas truck engine business. So we don’t see any big change in that front. And I think as we launch HPDI which gives the joint venture an exclusive proprietary product that people can’t match that’s just going to help its market share and its reputation. So is there going to be more engine competition in China? There is no doubt, it's pretty straight forward these days to take spark ignition you know conversion kits and put them on to an engine and so lots of people are doing that but you know the high performance and the high you know high reliability and with people like Weichai we think we’re going to continue to dominate.

Operator

This concludes the time allocated for questions. I’ll now hand the call back over to Darren Seed for closing comments.

Darren Seed

Thanks very much everyone for joining the conference call and we will see everyone in what would expect to be February of 2014 for the Q4 and year-end wrap up.

Operator

This concludes today’s conference call. You may now disconnect your lines. Thank you for participating and have a pleasant day.

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